Those who wrote $400 billion plus of protection on Lehman’s credit default swaps had been expected to make a substantial payout in the 80% to 85% of face value range, but the preliminary auction showed even worse results.

How the SEC and Treasury had so little clue that Lehman was in such bad shape is beyond me. The vagaries of permitting Level 3 accounting.

-Sellers of credit-default protection on bankrupt Lehman Brothers Holdings Inc. would be forced to pay holders 90.25 cents on the dollar under initial results of an auction today, setting up the biggest-ever payout in the $55 trillion market.

Preliminary results of the auction to determine the size of the settlement on Lehman credit-default swaps set an initial value of 9.75 cents on the dollar for the debt, according to Creditfixings.com, a Web site run by auction administrators Creditex Group Inc. and Markit Group Ltd. A final price is scheduled to be announced at 2 p.m. New York time.

The payment would be higher than indicated by trading in Lehman’s $128 billion of bonds yesterday. The debt was trading at an average of 13 cents on the dollar, indicating credit swap sellers would have to pay 87 cents.

More than 350 banks and investors signed up to settle credit-default swaps tied to Lehman. No one knows exactly how much is at stake because there’s no central exchange or system for reporting trades. It’s that lack of transparency that has increased the reluctance of financial institutions to do business with each other, exacerbating the global credit crisis and prompting calls for regulation of the market.

The list of participants includes Newport Beach, California-based Pacific Investment Management Co., manager of the world’s largest bond fund, Chicago-based hedge fund manager Citadel Investment Group LLC, and American International Group Inc., the New York-based insurer taken over by the government, according to the International Swaps and Derivatives Association in New York…..

BNP Paribas SA strategist Andrea Cicione in London estimated earlier today that a 20 cent recovery rate would lead to sellers paying out as much as $220 billion.

“Banks can go to the Federal Reserve, or use the commercial paper market where it is still functioning” to meet protection payments, said Cicione. “But fund managers or hedge funds, once they’ve used their cash, have only one option, to sell assets.”

Defenders of CDS had long argued that the guarantees were hedged with offsetting swaps. We are about to find out whether that true.

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26 comments

Can I get someone to clarify the mechanics of this? My quick read is that CDS buyers paid funds to CDS sellers in order to guarantee Lehman Bonds against default. At auction those Lehman Bonds are only generating purchase prices of $0.0975-on-the-dollar, so the CDS sellers who up to this time were paid to provide the CDS coverage must pay $0.925-on-the-dollar for every dollar of coverage provided. Accurate? Inaccurate? Omitted details? Do we know if the CDS market on those bonds exceeds the value of the bonds themselves, and if so will the contracts be honoured if the Insurer (Buyer) didn’t actually have anything to insure? Thanks.

Less than 10 cents recovery? So Lehman was less a bond house than a Potemkin village. I’d try to whip up some fresh outrage but I have the feeling that I’ll need to keep some in reserve for the coming months.

Because the over-the-counter credit derivatives market is murky, as The Deal's Vipal Monga states, it makes it difficult to know who has what exposure to Lehman CDSs. The most likely holders of the debt will include big banks such as Morgan Stanley, Goldman, Sachs & Co. and J.P. Morgan Chase & Co. The banks have been apparently hoarding cash in preparation for payouts.

FYI: Lawyers in most sophisticated jurisdictions have had difficulty signing off on any of these (derivative) structures because a transfer of value from the borrower to a creditor is occurring after the date of bankruptcy.

For these structures to work properly, it seems necessary, at a minimum, that all transfers of value from the borrower to the creditor should occur unambiguously on the same date as the original funding.

I’ve been studying the “credit default swaps” market for some time. It is said that there are $58 trillion of these outstanding. Though some are off setting many may be built on leverage and unreserved.

What will happen as a result of the Lehman auction today and similar events is that those solid institutions that underwrote CDS contracts which they than turned around and hedged with an off-setting CDO will still be obligated contractually for the CDO they underwrote while losing their protection to a bankrupt counter-party. They will than have unhedged exposure and may be taken down by the same bankruptcy or another depending on whom they underwrote. A few major bankruptcies will take down the whole $58 trillion edifice like a “house of cards.”

The only way to resolve this is for the U.S. government to declare “force majeure” and annul these contracts. Parties will be relatively little scathed financially as they will lose only the premium flow and un-callable protection where they have underlying securities to protect.

One of the most challenging issues associated with the development of the ISDA documentation has been the question of whether the contracts should cover restructuring events as well as bankruptcy or other more clear-cut default events.

Another issue in relation to the documentation of transactions is whether the trade documents are matched and confirmed in a timely fashion.

In regard to legal risk more generally, market participants are cognizant that legal issueshave previously arisen in the broader financial derivatives market in several areas. These include the risk that counterparties did not have the appropriate legal authority to enter into the transactions and the risk that a counterparty or customer may seek to avoid payment based, for instance, on the market participant’s failure to make adequate disclosures, or to assess the appropriateness of the transaction and its risks for the counterparty or customer.

Recommendation 7: Legal Documentation Risk All market participants need to pay careful attention to the legal documentation relating to CRT instruments, such as the range of credit events covered by the instruments and to the clear and unambiguous identification of underlying reference entities. In particular, credit hedging firms should specifically assess whether the reference entity in the underlying contract is the one to which they have credit exposure. A clear understanding of documentation is of particular importance for complex, structured CRT products.

@Steve Sposato. I agree with you, with one proviso. It seems clear to me that the govt should step in and allow only those w/ actual ownership of the bonds to settle up (I believe part of the problem is that people were buying default protection against bonds that they did not in fact own, correct?) For those who do not own bonds, they can be made whole (premium paid back) but should in no way be allowed to get full $.9025 on the dollar. This should cut down significantly the exposure of those who underwrote the Lehman CDOs.

imo this will be a damp squib. i reckon aig will turn out to be one of the biggest net writers of these contracts. if bonds were trading at 13c, then protection sellers will already have handed over 87c in cash collateral. i suspect it was lehman cds margin calls that contributed to aig’s capitulation (and reason why fed just had to lend aig a load more cash). mind you, the gap from 13c to 9.75c is not small, so could be some pain there..

Establishment of case basis reserves for unpaid losses and loss adjustment expenses on the Company’s in-force insurance and reinsurance business and assessing the amount of anticipated claims and recoveries on the Company’s in-force credit derivatives requires the use and exercise of significant judgment by management, including estimates regarding the likelihood of occurrence and amount of a loss on an guaranteed obligation.

As a result of the Company’s adoption of this revised presentation, changes in fair value of the Company’s credit derivatives are recorded in the line item of the accompanying consolidated statement of operations entitled “Net change in fair value of credit derivatives” which is required to be classified in the revenue section of the statement of operations. This line item consists of two components, which are also separately presented in the statement of operations: (1) “Realized gains (losses) and other settlements” and (2) “Unrealized gains and losses”. The “Realized gains (losses) and other settlements” component includes (i) net premiums received and receivable on issued credit derivatives, (ii) net premiums paid and payable on purchased credit derivatives, (iii) losses paid and payable to credit derivative counterparties due to the occurrence of a credit event and, (iv) losses recovered and recoverable on purchased credit derivatives due to the occurrence of a credit event. The “Unrealized gains and losses” component includes anticipated claims payable and anticipated recoveries, as well as all other changes in fair value.

At March 31, 2008 and December 31, 2007, the notional amount outstanding of the Company’s in-force CDS contracts was $63.3 billion ($58.3 billion net of back-to-back protection purchased by the Company) and $65.3 billion ($59.6 billion net of back-to-back protection purchased by the Company), respectively. The remaining weighted average life of such CDS contracts at March 31, 2008 was 10.9 years. In addition, based on such notional amount as of March 31, 2008 and December 31, 2007, approximately 69% and 93%, respectively, of referenced assets underlying such in-force CDS contracts were rated (based on Standard & Poor’s ratings) “AAA”, 20% and 7%, respectively, were rated at or above investment-grade, and 11% and less than 1%, respectively, were rated below investment-grade at such dates, respectively.

@ Sposato: The problem of your proposal is that the banks who used CDS for “regulatory arbitrage” – read circumventing regulatory requirements – would be even more undercapitalized than they are right now.

First, I’ll grant I’m none too bright. Now that is out of the way, why do I hear the CEO of Lehman complaining why he wasn’t saved. Should he have been backstopped until recovery was only 1 cent on the dollar (O, right, the economy was magically suppose to return to 4.5% growth per annum and Lehman could have leveraged to 130)

Just before the collapse of Lehman Brothers, executives at Neuberger Berman sent e-mail memos suggesting, among other things, that the Lehman Brothers’ top people forgo multi-million dollar bonuses to “send a strong message to both employees and investors that management is not shirking accountability for recent performance.”Lehman Brothers Investment Management Director George Herbert Walker IV, second cousin to U. S. President George Walker Bush, dismissed the proposal, going so far as to actually apologize to other members of the Lehman Brothers executive committee for the idea of bonus reduction having been suggested. He wrote, “Sorry team. I am not sure what’s in the water at Neuberger Berman. I’m embarrassed and I apologize.

“Can I get someone to clarify the mechanics of this? My quick read is that CDS buyers paid funds to CDS sellers in order to guarantee Lehman Bonds against default. At auction those Lehman Bonds are only generating purchase prices of $0.0975-on-the-dollar, so the CDS sellers who up to this time were paid to provide the CDS coverage must pay $0.925-on-the-dollar for every dollar of coverage provided. Accurate? Inaccurate?”

Inaccurate.

As I read the news story, this auction is to determine the value of the Lehman bonds. If the bonds were worth $0, then the CDS sellers (insurers) would have to pay 100% of the face value of the bonds. The bonds are said to be worth $.098 on the dollar, so the CDS sellers have to pay 91+% of the face value, which is more than previously revealed in the Lehman accounting. Whether the CDS sellers have the funds to pay off is the big question.

Good points, but how would one go about declaring “force majeure” when the definition is:

“Force Majeure (French for “superior force”) is a common clause in contracts which essentially frees both parties from liability or obligation when an extraordinary event or circumstance beyond the control of the parties, such as war, strike, riot, crime, act of God (e.g., flooding, earthquake, volcano), prevents one or both parties from fulfilling their obligations under the contract. “

Which terrible event would one claim when all parties were (supposedly) willing, able and all understood what their accountability was?

In the first big bankruptcy involving CDS, Delphi, the amount of CDS, as with Lehman, considerably exceeded the amount of bonds. The CDS documentation required that you deliver the bond. However, a massive scramble for bonds would have led to prices that in no way represented their settlement value in bankruptcy, and more important to all the participants, would have thrown the entire CDS market into chaos, since for pretty much every “reference entity”, there have been far more CDS written than the face amount of related bonds. They they devised the auction/settlement process and do NOT require delivery of bonds.

In hindsight, it might have been better to blow up the market back then, but no one was willing to do that.

“The only way to resolve this is for the U.S. government to declare “force majeure” and annul these contracts.”

I’ve been saying that all week; in essence, rescind the contracts. CDS’s are insurance policies — and recission is done routinely in the world of insurance — so what is the problem? Unwind them! Whatever the consequences, it can’t be half as bad as letting them continue to create the opacity that everybody says is the heart of the problem.

So when will the money actually start changing hands? When will we know, if ever, if someone or many someones are going to default? Do they have a time limit before they settle up, like a month or a day or? Do the holders of the contracts have to take them to court if they drag their feet, or make excuses?

Seems like the payoff/failure to payoff could drag out for months. How long did it take for things to get settled in that Delphi case?

Does anyone have any idea of the dollar amount of CDS’s outstanding in the Washington Mutual case? I have read several news articles about this whole thing, but there was never any estimate of the WaMu CDS’s outstanding.

@yves Thanks for your explanation about Delphi’s bankruptcy and its role. That was the final piece in the puzzle for me. I knew I had read something about a scramble for bonds under one of these contracts but it was so long ago, my addled brain simply couldn’t recall.